Welcome back to our blog series The Tao of Cash Flow: How To Manage Your Business Finances. Throughout this series, we have explored the important tips and techniques that we believe will help you to become a master of your business finances. In particular, we have focused on dealing with cash flow because that is one of the biggest causes of business failure and one of the most important aspects of finance to get right if you want to be successful in business.
This will be the last post in the cash flow series for a while. We want to move on to exploring other aspects of managing your business finances. This will include how to take money out of your business in the right way, how to understand the basic reports offered by your accounting software, and, with the government’s budget statement coming up in November, how to understand and prepare for paying taxes as a business.
Having already looked at the importance of cash flow, how to do a cash flow forecast, how to keep track of who owes you money, how to minimise your business expenses, how to ensure customers pay on time, and how to create a budget, today we will learn about the concept of “break-even”.
But before we get to that, let’s do a quick recap on two terms we learned last week. Those were fixed costs and variable costs. As we explained, “fixed costs” are costs that are fixed. They don’t change from month to month, they don’t change if you sell more or fewer products or services. For example, if you’re a store owner, the rent of your shop is likely to be the same every month. If you’re a sports franchise, you may pay a monthly venue hire fee for all the regular classes you run. These are fixed costs and they don’t change.
In comparison, there are variable costs. A variable cost, as the name suggests, is variable. In other words, it can change based on how much you sell each month. It could be that you are a cleaning franchise and if one month you have more to clean and another month you have less to clean, the number of cleaning products you need each month, or the amount of fuel you need to use to get to your clients, will be different.
You can also have semi-variable costs. These are costs that have both fixed and variable elements but don’t worry too much about that for now.
What is Breakeven?
So what is break even? Break-even is the point at which your business “breaks even.” This is the point at which your money into the business exactly matches the money out. In other words, the money from your sales is the same as your costs. Any further sales you have after this point means you are beginning to make a profit. It is a very important milestone and will be the first sign that your business is becoming a success.
Why is it important?
Understanding your break-even point is important for a variety of reasons. First, it will show you when your business will finally start making a profit and how long it will take you to reach this point. It is important to understand when you will start making profits as before this point you are making a loss. Therefore need to have finances in place to cover these. Ideally, you would want to have done this analysis before you start a business so that you know whether it is even a feasible business.
Second, knowing your break-even point will give you a goal to aim towards so you know how many sales you need to make a month, or how many customers you need to have. And knowing that will determine many other aspects of your business such as what marketing you choose to do.
Third, it can help you test different prices in the model. Then you can see how changes in the price would affect your ability to break even and make a profit.
However, there are some limitations to this analysis too. Ultimately it is based on your estimates of costs so you need to be as accurate as possible with these.
How to work out your break-even point
In previous blogs in this series, we have asked you to have a list of your costs. In order to move forward with working out your break-even point, you’re going to need to have these to hand. Please make sure you have them available for working through this
1) The first stage in working out your break-even point, is to know how much your fixed and variable costs are. Go through each cost you have in the business and decide whether it is fixed (unchanging) or variable (changes as the amount you sell changes). If the cost has elements of both, it is semi-variable. You may want to contact us to help you work out these how much of these costs are fixed and how much are variable. Once you’ve decided which costs are variable and which are fixed, you need to add them up. You’ll have two figures – the total of all your fixed costs and the total of all your variable costs. It is probably a good idea to focus on the costs per each month rather than any longer period.
2) The next stage is to consider the selling price. This means you should know the price you sell your goods or services for. As a franchise, you probably have a recommended price for your product or service set by your franchisor – this would be the best price to use in the formula. Alternatively, with multiple products, you may need to work out an average price but this may lead to less accurate results. If you have a product or service you only sell now and again, it might be best to ignore it in the calculations for now, unless it represents a significant proportion of your income.
3) There is one more piece of the puzzle required before we can use the break-even formula. We need to know the “variable cost per unit”. Essentially this is how much the variable cost is for each unit of product or service. For example, if you do sports classes, you should work out how much each sports class costs you to run. But you should only take into account variable costs, not fixed costs. You’ve already added up all your variable costs, so now you can work out what they are per “unit” of product or service.
If you have added this up for say, a month, you will need to do a calculation. To do this simply divide the total of your variable costs, by the number of units. For example, let’s say your variable costs per month are £400. And let’s say you have 20 customers who each attend a class once a week. That means you have essentially 80 “units” (20 customers x 4 classes) a month. If you then divide the £400 by 80 “units”, you end up with a variable cost of £5 per customer per class.
4) Ok, so now you have everything you need – you should have three figures. These are the selling price of your product or service, the total of your fixed costs, and your variable cost per each “unit”. We can now put these into a simple formula and come up with a break-even point.
The formula is:
Fixed costs ÷ (price – variable cost per unit)
So go ahead and put in your total fixed costs figure, the price you charge, and the variable cost you calculated in point three. Press the ‘=’ sign and see what number comes back. You now have a number that shows how much of your product or service you need to sell each month to break even. If you sell more than that, you will make a profit. If you sell less than that, you will make a loss.
Now that you have this very important piece of information you can start to consider your next steps. Are you already past your break-even point? If so, well done and keep going. If not, what can you do about it? Do you need to up your marketing? Do you need to change your prices (but remember to talk with your franchisor first)? What finances do you need to have in place to cover for your losses until you reach the break-even point? Information is power, and now you have information that can help you make important decisions for your business, and help you work towards becoming a success.
Well, that’s the end of the blog this week, and the end of this series for a while. We really hope you have enjoyed the blogs and that they have been helpful for you. By implementing all the steps we have recommended within your business, you can be sure that you will have a strong grip on your business finances and your cash flow, you will be able to prepare well for the future and prepare for any problems, and you will be able to run your business successfully.
If there is one thing we would recommend that you take away from this, it’s to have a weekly scheduled time when you focus on your business finances – creating your invoices and expenses, chasing up customers who haven’t paid, looking at your cash flow forecast and budgets, and so on.
If you are unsure about anything we have talked about in this series, please don’t hesitate to give us a call and we can talk you through it.
In future blogs, we will explore other areas of managing your business finances to equip you with the skills you need to run your business effectively and efficiently, so don’t forget to subscribe. And if you find these posts useful, please share them through social media using the buttons below.
Finally, to find out more about how PayKeeper can help you, please call us on 0330 111 66 33.